Monday, 16 January 2017

There is much on-going controversy in the financial advice industry amongst regulators, so-called and real advisors and their firms and consumer advocates about the current suitability standard for recommending investments versus a possible best interests standard.

There are three main issues:

1) suitability definitions (e.g. IIROC Rules or Ontario Securities Commission requirements) for investment industry salespeople are meant to stop abusive practices. Most often this involves putting clients into highly risky, high cost securities. This issue accounts for 99% of the whole suitability vs best interests debate.

2)
suitability for someone like me, a reasonably informed self-directed
investor (who thereby has no ethical conflicts), equates to the best
interest standard. The only thing that's suitable for me is what's best for me. ... But it still leaves a very wide possible variation
of investments. I could probably ask three highly experienced,
completely ethical true financial advisers to tell me what investments
to make and I could probably get three very different answers. This
reality shows up in the definitions - beyond the words
about Know Your Client and Know Your Product, the regulatory definition of suitability is still either circular where the
word suitable itself is repeated, or it says something vague like "must apply
sound professional judgement". That's because there is no single correct best answer even when you take into account risk tolerance and risk capacity, short and long term objectives, complete financial circumstances, including taxes and so on. The world, and life, is too uncertain to be sure you have what will turn out to be the best answer. I can say that things get even more
complicated in retirement when additional factors become as or more
important than the investment portfolio, such as future inflation,
unknown longevity, other products like annuities, unknown health, mental
decline, account choice for holdings and withdrawals (TFSA, RRSP, RLIF, regular), CPP and OAS changes by the government. If you don't believe me, peruse the writings of Wade Pfau whose research seems not to (yet?) have uncovered, after probing many suggested approaches, a right answer on how to organize the investment side alone. For example, see this discussion of three ways to incorporate bonds in a retirement portfolio about which he notes "Scholars and practitioners have numerous disagreements about the best way to incorporate bonds into a real-world retirement income plan."

3) suitability can and should also apply at
the portfolio level, not just individual securities, funds or ETFs.
Asset allocation is a powerful risk mitigation tool that works at the
portfolio level. Thus, robo services that propose and actually implement
collections of ETFs with rebalancing rules should not have to apply a
suitability judgment against individual ETFs - a more volatile
emerging markets ETF as a minor portfolio component with USA equity and a
bond fund can reduce overall volatility and that would make it ok even for a conservative investor. On its own, it would probably not be ok however.

When all is said and done, I believe, for example, that a low fee balanced equity - fixed income fund (such as Larry Macdonald's One Minute Portfolio or our similar Reluctant Investor's Lifelong Portfolio) is suitable
for everyone and anyone, of whatever age or financial circumstances. Why? simply because it is not unsuitable. The
anti-definition is best >> What is suitable? = Anything that is
clearly not unsuitable.

Eliminating the Unsuitable by avoiding dangers
In practical terms, a default automatic suitability pass could consist of individual securities, mutual funds, ETFs or portfolios with all of:

no leverage

no use of derivatives

low fees, for example under 0.75% MER

diversification, such as individual mutual funds or ETFs with holdings of 50 or more individual securities

avoid over-concentration by holding less than 10% of total portfolio value in individual securities, which also must be listed in the TSX Composite index, or S&P 500

fixed income (individual) with ratings of investment grade or funds with no less than 70% investment grade holdings

portfolios (such as robo advisors provide) of equity combined with fixed income where each of the two is limited to 30% to 70% of the total value

minimum liquidity characteristics, an exact number for which I cannot suggest but would be based on trading volumes in a public market

It's quite possible that other securities could pass the suitability test - indeed one of my favourite and highly suitable funds is BMO's Low Volatility Canadian Equity ETF with only 46 holdings. Such alternatives would need to have more justification as to why they are suitable e.g. low volatility is very beneficial for a retired investor to reduce sequence of returns risk (a large market drop early in retirement combined with portfolio withdrawal causing an irretrievable reduction in the portfolio) while retaining the equity exposure.

Such a restrictive approach to suitability as the above makes investing simpler and allows the focus to shift to the other elements of financial management for individuals, which is where it should be.

3 comments:

Only Canadian stocks in the "low risk" portfolio? This, to my mind, is not a suitable portfolio for anyone. In my opinion, any portfolio must have international diversification, at the very least some US stocks.

I do agree that a portfolio can benefit from international diversification, especially over the long term (my own has about a third of its total value in USA, developed and emerging equities). The returns will likely be a bit better and the overall volatility less. But I think the other points in my suitability criteria list outweigh international diversification in importance since they can undermine results a lot more and a lot faster.

Larry Macdonald's One-Minute portfolio, which has only Canadian equity, shows that such a portfolio can do very well over the long term. So, in my mind, international diversification is good to have but not essential.